FINANCIAL RISK MANAGEMENT

CHAPTER 4
CREDIT RISK
(Hull, Chapter 14)

1
OUTLINE
 How Credit risk arises?
 Definition
 Categories of credit risks
 Credit Ratings
 Altman’s Z-score
 Estimating Default Probabilities
 Credit Exposure Management
 Managing Credit Risk
 A major part of the business of financial institutions is
making loans, and the major risk with loans is that the
borrow will
not repay.
 Credit risk is the risk that a borrower will not repay a
loan according to the terms of the loan, either defaulting
entirely or making late payments of interest or principal.
How Credit Risk Arises?
 Activities such as lending, investing, credit granting,
performance of counterparties in contractual agreements
(i.e. derivatives)

 Poor economic conditions & high interest rate give rise to

likelihood of default.
 Credit risks include:
1. Default risk (traditional credit risk)
Default of payment related to lending / sales.
2. Counterparty Pre-settlement Risk
Arise from possibility of counterparty default once contract
has been entered into but prior to settlement.
3. Counterparty Settlement Risk
is a transaction risk arising from the exchange of payments
between parties to agreement.
4. Legal Risk
 risk that organization is not legally permitted or able to enter
into transactions, particularly derivatives transactions.
 The risk extends to individuals who make decisions on behalf
of counterparties & their level of authorization to enter into
transactions.
 More complex if involves international financial operations
(foreign law apply).
5. Sovereign / Country Risk
 Arise from legal, regulatory & political exposures in
international transactions (restrictions & regulations of
foreign government)
 Problems may arise with issuer’s (even debt issuer have high
quality credit rating) ability to fulfill its own obligations in
environment that becomes financially / politically hostile
6. Concentration Risk
 Affects organizations with exposure that is poorly diversified
by region or sector.
 A bank with large number of borrowers in a particular
industry sector is vulnerable to industry concentration risk.
 i.e. customers based concentrated in specific region, having
one / two major customers
Credit Ratings
 In the S&P/Fitch rating system, AAA is the best rating.
After that comes AA, A, BBB, BB, B, and CCC
 The corresponding Moody’s ratings are Aaa, Aa, A, Baa,
Ba, B, and Caa
 Bonds with ratings of BBB (or Baa) and above are
considered to be “investment grade”
 Most banks have their own internal ratings systems for
borrowers
If the Z>3.0 default is unlikely; if 2.7<Z<3.0 we should be on alert. If
1.8<Z<2.7 there is a moderate chance of default; if Z<1.8 there is a high
chance of default
Exercise
Consider following figures for a company:
 Working capital = RM20,000
 Retained earnings = RM350,000
 Earnings before interest and taxes = RM80,000
 Market value of equity = RM420,000
 Book value of total liabilities = RM260,000
 Sales = RM240,000
 Total assets = RM800,000
 Estimating Default Probabilities

 Alternatives:
1. Use historical data
2. Use CDS spreads
3. Use bond prices or asset swaps

14
 1. Historical Data

Historical data provided by rating agencies can be used to

estimate the probability of default

15
 Cumulative Average Default Rates % (1970-
2007, Moody’s) Table 14.1, page 292
Time (years)
1 2 3 4 5 7 10
Aaa 0.000 0.000 0.000 0.026 0.100 0.252 0.525

Aa 0.008 0.018 0.042 0.106 0.178 0.344 0.521

A 0.020 0.094 0.218 0.342 0.467 0.762 1.308

Baa 0.170 0.478 0.883 1.360 1.835 2.794 4.353

Ba 1.125 3.019 5.298 7.648 9.805 13.465 18.426

B 4.660 10.195 15.566 20.325 24.692 32.527 40.922

Caa 17.723 27.909 36.116 42.603 47.836 54.539 64.928

At end of 1st year has 0.170% chance of defaulting

At end of 2nd year has 0.478% of defaulting

Therefore, probability will default in 2nd year is 0.478%-0.170% = 0.308%

16
Interpretation
 The table shows the probability of default for companies
starting with a particular credit rating
 A company with an initial credit rating of Baa has a
probability of 0.170% of defaulting by the end of the first
year, 0.478% by the end of the second year, and so on

17
 Do Default Probabilities Increase with Time?
 For a company that starts with a good credit rating default probabilities tend to
increase with time
Year 1 2 3 4 5
Aa 0.008 0.018 0.042 0.106 0.178
Default
0.08 0.010 0.024 0.064 0.072
Probability

 Because bond issuer is initially considered to be creditworthy, and the more

time elapses, the greater possibility that its financial health will decline
 For a company that starts with a poor credit rating default probabilities tend to
decrease with time
Year 1 2 3 4 5
Caa 17.723 27.909 36.116 42.603 47.836
Default
17.723 10.186 8.207 6.487 5.233
probability

 Because next 1 or 2 year maybe critical, if survived this period, its financial
health likely to improve
18
 Default Intensity vs Unconditional
Default Probability
 The default intensity or hazard rate is the probability of
default conditional on no earlier default
 The unconditional default probability is the probability of
default as seen at time zero
 What are the default intensities and unconditional default
probabilities from the Moody’s table for a Caa rate company
in the third year?

19
What are the default intensities and unconditional default
probabilities from the Moody’s table for a Caa rated
company in the third year?
Year 1 2 3 4 5 6 7
Caa 17.723 27.909 36.116 42.603 47.836 54.539 64.928
Default
17.723 10.186 8.207 6.487 5.233 6.703 10.389
probability

Unconditional default probability

Probability Caa-rated will survive until end of year 2 is

100% - 27.909% = 72.091%

Hazard rate or default intensity = 0.08207/0.72091 = 11.38%

 Recovery Rate
 When company bankrupt, those that are owed money by
company file claims against the assets of the company
 Reorganization of debt where creditors agree to pay partial
payment of claims
 Assets sold by liquidator, proceeds used to meet claims
payment
 Recovery rate for a bond: defined as the price of the bond
immediately after default as a percent of its face value
 Some claims typically have priorities over other claims

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 Recovery Rates; Moody’s: 1982 to 2007
(Table 14.2, page 293)

Class Mean(%)

1st paid in the event

Senior Secured 51.89
Of default
Average recovery rate
Is 51.89 cents/Dollar
Senior Unsecured 36.69 Face value
Have priority ahead
Of all other unsecured
Senior Subordinated 32.42

Subordinated 31.19
Subordinated debt
Repaid only after
Senior debt has
been repaid
Junior Subordinated 23.95 23.95 cents/Dollar
Face value

Recovery rate significantly NEGATIVE correlated with default rate

22 R2 of regression is about 0.5
 Recovery Rates Depend on Default
Rates
 Moody’s best fit estimate for the 1982 to 2007 period is
Average Recovery Rate % =
59.33 − 3.06 × Spec Grade Default Rate%
i.e.
Default rate on speculative bond in a year is 1%
Average recovery rate = 59.33 – 3.06 x 1 = 56%
Default rate at 10%
Average recovery = 59.33 – 3.06 x 10 = 28.73%
The relationship means a bad year for the default rate is usually
DOUBLY bad because it accompanied by LOW recovery rate
23
 2. Credit Default Swaps (CDS) (page 294)
Instrument that provides insurance against the risk of default
by particular company

 Buyer of the instrument acquires protection from the seller against

a default by a particular company or country (the reference entity)
 Example: Buyer pays a premium of 90 bps per year for $100
million of 5-year protection against company X
 Premium is known as the credit default spread. It is paid for life of
contract or until default
 If there is a default, the buyer has the right to sell bonds with a
face value of $100 million issued by company X for $100 million
(Several bonds may be deliverable)

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 CDS Structure (Figure 14.1, page 294)

Make periodic payment until end of CDS life or credit event (default)
90 bps per year

Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
“Reference Entity” reference entity=L(1-R)

Recovery rate, R, is the ratio of the value of the bond issued

by reference entity immediately after default to the face value
/ notional principal of the bond

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 Other Details
 Payments are usually made quarterly in arrears
 In the event of default there is a final accrual payment by
the buyer
 Settlement can be specified as delivery of the bonds or in
cash (several bonds are usually deliverable)
 Suppose payments are made quarterly in the example
just considered. What are the cash flows if there is a
default after 3 years and 1 month and recovery rate is
40%? (example pg 295)
 Face value $100 million
 CDS requires quarterly payment at rate 90 bps per
annum, payment made once a year.
 5 year CDS contract entered on March 1, 2009
26
 Make periodic payment until end of CDS life or credit event (default)

90 bps per year

Face Value $100million
Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
“Reference Entity” reference entity=L(1-R)

1/3/2009 1/3/2010 1/3/2011 1/3/2012

CF1=$900k CF3 = $900k Default

CF2=$900k

At time of default
100 bps = 1% 1 month accrual payment
90bps = 0.9% = $100,000,000 x 0.0090 x 1/12
So, yearly cash flows buyer paid to seller is = $75,000
0.9% x $100million x 3/12 = 225,000 (quarterly premium) At time of default, Payoff is
= 0.0090 x $100,000,000 x 12/12 = L(1-R)
= $900,000 (yearly CF paid to seller) = $100,000,000 (1-0.4)
=$100,000,000 (0.6)
=$60,000,000
Question:
 A CDS requires semi annual payment at the rate of 60 basis points
per year. The principle is $300million and the CDS is settled in
cash. A default occurs after 4 years and 2 months, and the
calculation agent estimates that the price of the cheapest
deliverable bond is 40% of its face value shortly after the default.
1. List the cash flows and their timing for the seller of the CDS
2. Calculate the final accrue payment and the payoff amount.
 Make periodic payment until end of CDS life or credit event (default)

60 bps per year

Face Value $300million
Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
“Reference Entity” reference entity=L(1-R)

Year 0 0.5 Year 1 1.5 Year 2 2.5 Year 3 3.5 Year 4

Default

CF1=$900k CF3=$900k CF5=$900k CF7=$900k CF9 = $300,000

CF2=$900k CF4=$900k CF6=$900k CF8=$900k

At time of default
100 bps = 1% 2 months accrual payment
60bps = 0.6% = $300,000,000 x 0.0060 x 2/12
So, semi-annual cash flows buyer paid to seller is = $300,000
6% x $300million x 6/12 At time of default, Payoff is
= 0.0060 x $300,000,000 x 0.5 = L(1-R)
= $900,000 = $300,000,000 (1-0.4)
=$300,000,000 (0.6)
=$180,000,000
 Attractions of the CDS Market

 Allows credit risks to be traded in the same way as market risks

 Can be used to transfer credit risks to a third party
 Can be used to diversify credit risks

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 Credit Indices (page 297-98)
 CDX IG: equally weighted portfolio of 125 investment
grade North American companies
 iTraxx: equally weighted portfolio of 125 investment
grade European companies
 If the five-year CDS index is bid 165 offer 166 it means
that a portfolio of 125 CDSs on the CDX companies can
be bought for 166bps per company, e.g., $800,000 of 5-
year protection on each name could be purchased for
$1,660,000 per year. When a company defaults the
annual payment is reduced by 1/125.

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 3. Credit Default Swaps (CDS) and Bond Yields
(page 298)
 Credit spreads: extra rate of interest required by investors for bearing a
particular credit risk.
 CDS can be used to hedge a position in a corporate bond
 Types of credit spreads:
1. CDS spread: total amount paid in a year to purchase protection as a
percentage of Face Value
2. Bond yield spread: amount of yield on corporate bond exceeds the yield on a
similar risk-free bond
 n-year CDS spread should be approximately equal to the excess of the par
yield on a n-year corporate bond over the par yield on an n-year risk free
bond. (note: par yield on a n-year bond is the coupon rate per year)
 If less: investor can earn more than risk-free rate by buying corporate bond
and buying protection
 If greater: investor can borrow at less than the risk-free rate by shorting
corporate bond and selling CDS protection
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Question:
 Portfolio consisting of a 5-year par yield corporate bond
that provides a yield of 6% and a long position in a 5-
year CDS costing 100 basis points per year is
(approximately) a long position in a riskless instrument
paying 5% per year
 What are arbitrage opportunities in this situation is risk-
free rate is 4.5%? What if it is 5.5%?
100bps CDS spread = 1%
@4.5% => 6%-4.5% = 1.5%, …1 < 1.5% => Buy cb & buy
protection
@5.5% => 6-5.5%=0.5%, …1>0.5 => short CB, sell protection
 Risk-free Rate
 The risk-free rate used by bond traders when quoting credit
spreads is the Treasury rate
 The risk-free rate used in the credit markets is the
LIBOR/swap rate

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 Asset Swaps
 Asset swaps are used by the market as an estimate of the
bond yield relative to LIBOR
 The present value of the asset swap spread is the present
value of the cost of default

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 Asset Swaps (page 299)
 Suppose asset swap spread for a particular corporate bond is 150
basis points
 One side pays coupons on the bond; the other pays LIBOR+150
basis points. The coupons on the bond are paid regardless of
whether there is a default
 In addition there is an initial exchange of cash reflecting the
difference between the bond price and $100
 The PV of the asset swap spread is the amount by which the price
of the corporate bond is exceeded by the price of a similar risk-
free bond when the LIBOR/swap curve is used for discounting

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 Using CDS Prices to Predict Default
Probabilities
Average default intensity over life of bond is
approximately
s
1 R
where s is the spread of the bond’s yield over the risk-
free rate and R is the recovery rate

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 More Exact Calculation for Bonds
(page 262)
 Suppose that a five year corporate bond pays a coupon of 6% per
annum (semiannually). The yield is 7% with continuous
compounding and the yield on a similar risk-free bond is 5% (with
continuous compounding)
 The expected loss from defaults is 8.738. This can be calculated as
the PV of asset swap spreads or as the difference between the
market price of the bond and its risk-free price
 Suppose that the unconditional probability of default is Q per year
and that defaults always happen half way through a year
(immediately before a coupon payment).

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 Calculations
Time Def Recovery Risk-free Loss Discount PV of Exp
(yrs) Prob Amount Value Factor Loss
0.5 Q 40 106.73 66.73 0.9753 65.08Q

1.5 Q 40 105.97 65.97 0.9277 61.20Q

2.5 Q 40 105.17 65.17 0.8825 57.52Q

3.5 Q 40 104.34 64.34 0.8395 54.01Q

4.5 Q 40 103.46 63.46 0.7985 50.67Q

Total 288.48Q

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 Calculations continued
 We set 288.48Q = 8.738 to get Q = 3.03%
 This analysis can be extended to allow defaults to take place
more frequently
 With several bonds we can use more parameters to describe
the default probability distribution

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40 Chapter 14, Copyright © John C. Hull 2009
 Real World vs Risk-Neutral Default
Probabilities
 The default probabilities backed out of bond prices or credit
default swap spreads are risk-neutral default probabilities
 The default probabilities backed out of historical data are
real-world default probabilities

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 A Comparison
 Calculate 7-year default intensities from the Moody’s data
(These are real world default probabilities)
 Use Merrill Lynch data to estimate average 7-year default
intensities from bond prices (these are risk-neutral default
intensities)
 Assume a risk-free rate equal to the 7-year swap rate minus
10 basis points

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42 Chapter 14, Copyright © John C. Hull 2009
 Real World vs Risk Neutral Default
Probabilities (7 year averages) Table 14.4,
page 304

Rating Historical Default Default Intensity from Ratio Difference

intensity (%) bonds
Aaa 0.04 0.60 16.6 0.56
Aa 0.05 0.74 15.0 0.69
A 0.11 1.16 10.6 1.05
Baa 0.40 2.13 5.3 1.73
Ba 2.07 4.67 2.3 2.60
B 5.62 7.97 1.4 2.15
Caa 11.26 18.16 1.6 6.90

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 Risk Premiums Earned By Bond
Traders (Table 14.5, page 304)

Rating Bond Yield Spread of risk-free Spread to Extra Risk

Spread over rate used by market compensate for Premium
Treasuries over Treasuries default rate in the (bps)
(bps) (bps) real world (bps)
Aaa 78 42 2 34
Aa 87 42 3 42
A 112 42 7 63
Baa 170 42 24 104
Ba 323 42 124 157
B 521 42 337 142
Caa 1132 42 676 414

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44 Chapter 14, Copyright © John C. Hull 2009
 Possible Reasons for These Results
(The third reason is the most important)

 Corporate bonds are relatively illiquid

 The subjective default probabilities of bond traders may
be much higher than the estimates from Moody’s
historical data
 Bonds do not default independently of each other. This
leads to systematic risk that cannot be diversified away.
 Bond returns are highly skewed with limited upside. The
non-systematic risk is difficult to diversify away and may
be priced by the market

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 Which World Should We Use?
 We should use risk-neutral estimates for valuing credit
derivatives and estimating the present value of the cost of
default
 We should use real world estimates for calculating credit VaR
and scenario analysis

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46 Chapter 14, Copyright © John C. Hull 2009
Credit Exposure Management
1. Credit Risk Function
 Setting appropriate credit exposure limits, monitoring &
reporting exposures against limits on an aggregate,
collateral & other credit enhancement techniques,
determining method & frequency for reviewing credit
policies.
2. Diversification
Diversify the company’s credit exposure i.e. customers from
different industry
3. Credit Rationing
credit granted where most attractive risk-to-return tradeoff
available by assigning higher rate to higher risk transaction to
compensate for the additional risk
4. Collateral
derivative exchange – margin repo transaction or repurchase
agreement
A procedure for borrowing money by selling securities to a
counterparty and agreeing to buy them back later at a slightly
higher price
5. Netting agreements
amount to be exchanged between counterparty are netted –
minimize settlement risk

6. Marking-to market
 financial institutions has to estimate a value for each financial
instrument in its trading portfolio & calculate total value of
portfolio
 Gain & losses are compared to limits – actions taken to protect
gains & risk mitigation action taken should unrealized loss exceed
predetermined limit
7. Credit Limits
 financial institution involved in trading actively use position
limit to restrict the size of a trading position & loss potential
 Limit for individual traders are set based on experience,
performance, risk measurement & modeling and the
institution’s risk tolerance
 Both daylight limits (during trading day) & overnight limits
(for open positions and trading in foreign market) are used
8. Credit derivatives
 Contractual agreements based on credit performance (default,
insolvency, non-payment of loan, downgrading by rating
agency), the event must be predetermined and readily
identifiable when it occurs. i.e. bankruptcy
 It provides a mechanism permitting the transfer of unwanted
risk between willing counterparties/organizations with too
much credit risk to organization willing to assume it (similar
to insurance business)
Other techniques
 Secures lending transaction
lending is secured with assets of value, credit insurance

 Debt covenants
designed to protect creditors & require borrower to maintain
certain financial conditions, i.e. limit debt to a specific % of
capital